I talked about taking some “action” in my last net worth update. We both contributed $5,000 each to a non-deductible Traditional IRA earlier this week. In doing so, I was reminded of how some folks can be intimidated by the amount of IRS fine print you must read every time you try to achieve some tax savings. Perhaps it is a small minority, especially of people reading this, but still significant.
Just to figure out if we were allowed to contribute took some searching. Per this IRS flowchart, because we are married filing jointly and will most likely have a modified adjusted gross income (MAGI) over $177,000, we are unable to contribute to a Roth IRA. How many people know what their MAGI is? In this world of spiraling credit card debt, how many people are willing to try to figure it out?
However, anyone can contribute to a Traditional IRA, even though it doesn’t explicitly state that anywhere. Then the question is whether it is tax-deductible. From this other IRS flowchart, because we are married filing jointly, covered by a retirement plan at work, and have an MAGI of over $109,000, I figure out that our contribution is not tax-deductible.
Finally, I happen to know in 2010, there is no income limit on the conversion from a Traditional IRA to Roth IRA. I must rely on the many mentions from financial media and investment brokers to know this. Even so, there are even more catches in terms of pre-tax and post-tax bits of the IRA to be converted.
I personally don’t mind all of this. But there must be a study somewhere that shows that every time a person has to walk themselves through an IRS flowchart, the overall IRA participation rate drops something like 5%.
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Jonathan,
You make a great point. Obviously these IRA rules are far too difficult to understand, and that reduces participation.
Here is another, even more complicated IRA maneuver that I completed, in which some of your readers may be interested:
I wanted to convert my non-detectable IRA to a Roth IRA. Given my non-deductible contributions, one would think that I could do so without paying much tax on the conversion. (My non-deductable contributions were almost as large as the total money in the IRA.)
However, I also had a Roll-over IRA that was converted from a 401(k) plan at a previous employer. As you know, the IRS rules do no allow me to convert the non-deductable IRA without also converting the Roll-over IRA. Converting this Roll-over IRA would have cost me a lot of taxes for tax year 2010 which I did not want to pay.
So here is what I did to avoid the problem:
(1) I transferred the Roll-over IRA to the 401(k) plan at my current employer.
(2) I then converted the non-delectable IRA to a Roth IRA.
Because the Roll-over IRA no longer exists, I am not required to convert it to a Roth IRA. I was able to convert the non-deductable IRA to a Roth IRA without paying much in taxes.
That’s why people pay what they do to tax accountants. People already have enough on their plate and would rather spend their time doing something more full-filling than worry about all the many little nuances and caveats of the tax code.
I guess then i’m just a little awkward since i actually like learning about the minute details in the tax code.
Jonathan, i sent information about the following article to your email but figured my message might get tossed out with the junk mail. So i’m posting the same info here for you and your readers.
This Natalie Choate article about sidestepping the Roth Contribution limit was an eyeopener for me. I would definitely recommend that people consult their advisor BEFORE following through on the Roth conversions mentioned in the article. This link should take you to the article: http://www.morningstaradvisor.com/articles/article.asp?docId=18912
Is this no limit conversion to Roth only for 2010 ? How about in 2011 and beyond …
I am confused about whether a non-deductible IRA would benefit me. My wife and I both work well paying jobs and are above the income limits mentioned in your post. All of our income is salary so we pay a lot of taxes. We both already max out our 401k contributions each year. Currently we put any leftover money either toward paying down our mortgage or in a vanguard account into one of the target retirement funds.
Are we eligible for a non-deductible IRA?
What benefit would we get from it?
Thanks…
I may be mistaken, but as MM said, you should be able to convert the Traditional IRA to a Roth in 2010. Even without a deductible contribution, your money grows and is spent tax free in a Roth.
MM: The income limits have been removed until further notice!
Derek: This is great day for you because I have great news. Your leftover money that you usually put toward extra mortgage payment or into Vanguard index funds can be re-directed into a non-deductible IRA, then you may choose to convert it all into a Roth IRA. Thanks to the new rules that remove the income limit for converting to Roth, you can now convert your IRA into a Roth IRA regardless of your income.
You noted, “anyone can contribute to a Traditional IRA, even though it doesn’t explicitly state that anywhere”. Anyone who has produced income, correct?
Yes, Mike you have to have EARNED income, or a spouse with earned income.
The real big deal is making sure to keep track of your basis in the nondeductible IRA.
I 100% agree with you, it’s very overwhelming. I too made non-deductible contributions over the past few years to a Traditional IRA. I filed all the appropriate paperwork with the IRS (thank you Turbo Tax) but now the time has come for me to convert and I can’t for the life of me figure out how much I would actually owe in taxes to convert it all to a ROTH (with the added problem that I co-mingled the funds with Traditional IRA funds that were a deductible contribution)… I too have Vanguard and I’m thinking it might be time to call them and say “help!”… unless you have a resource I haven’t thought of for figuring out the taxes…
You could contribute to a Roth 401K which has no income restrictions, then roll it into a Roth IRA.
Liberty,
If I recall my rules right, even if you would not have commingled your fund it did not matter, it is the ration. Let us say you had a IRA that you had $100,000 put into is, $10,000 of which is a non deductible (or basis) the 10% of each amount you convert would be nondeductible, there for 10% would not be subject to tax.
TC, your employer has to offer one first not all do, then you have to have an event (like a job change) that would allow you to to move it to a ROTH
I’m very confused by this… Let’s say I’ve made a non-deductible contribution of $5K last year. I should be able to convert that to a ROTH tax free in 2010, but what does it matter if I have other traditional IRAs so long as they are not pooled? I also have a SEP IRA, does that need to be pooled with my last years contribution to determine the conversion %… I don’t think she gave enough details in her analogy.
I did pool them… that’s the problem. I didn’t think about it at the time and just added the money to an already existing traditional IRA that was a deductible contribution, so the funds are now commingled. And trying to figure out how much was from the first contribution versus the additional contributions will take a little forensic accounting, which is not my expertise. I think I need to sit down with an accountant, this makes my brain hurt… It wouldn’t be so bad if I had just added 1 additional contribution, but I’ve added 4 years worth, since I first heard about the conversion cap of $100k being lifted and then the market tanked and well, here I am… 🙂
I have joint income that does not qualify me for roth this year. i also have 401ks from last 2 employers that i havent rolled over. If i open a traditional ira now, can i just convert that to roth ira without touching my other 401ks?
Liberty, it’s actually not all that complicated. It doesn’t matter whether you “pooled” your contributions or not. You simply take the total amount of your non-deductible contributions and divide by the total value of all of your IRAs (deductible, non-deductible, and mixed) at conversion. Use this ration to determine your non-taxable portion of funds that you intend to convert. You can convert any amount you want. If you don’t convert all of your IRAs in one year, you subtract the non-deductible amount from your first conversion and subtract it from the total non-deductible conversions that you originally made. You take that new non-deductible amount and divide by the total value of your IRAs (just like you did the first time). This new ratio will apply to your second conversion to determine a non-taxable amount. Continue to follow this procedure until you have fully converted all of your IRAs.
Tapping into what Derek mentioned above. I’m in the same position. My wife and I file jointly and we max out 401k. We put the rest in non deductible IRA. I understand the income limits are off this year so I can convert. This is GREAT but what about 2011? My income will be above 177k so I will not be able to contribute to that Roth IRA I just converted to. I’ll had to open another non deductible IRA, correct?
@Andy – Yes, and I believe you can convert that into the same Roth IRA again in 2011 since there are no income limits again.
Good to know!! Do we know know kong this loophole will be open? I ask because I’m trying to figure my best options to invest for everything from College to intermediate savings, and retirement. I max out my 401k but my income is to high to do a Roth IRA. If this loophole is going to be open forever, going the route of contributing to a nondeductible IRA and converting it to a Roth IRA every year may be better than going with a Whole Life insurance policy to dump my investment money (whole life because of the tax advantages and fact Incan take put money somewhat penalty free for college for kids, etc). I’d hat to build a plan around being able to do a Roth conversion every year and then have it taken away.